Final Review of Facebook’s Business Model and Common Stock

Posted here is my final review and analysis of Facebook for investors and those considering purchasing ownership in the company. Again, this absolutely does not constitute direct investment advice. You should consult professional advice and access your personal situation and the risks involved in any investment activity.

Analyst Report: Facebook

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Facebook and Atlas: Evolution and the Match Made in Heaven

Despite the fact that I’m in an increasingly disturbed and pessimistic mood today, largely bolstered by the barista’s incompetence with the simple task of making my upside-down caramel macchiato this evening. Really, how truly difficult is it to remember the simple phrase “upside down, please”—I know, first world problems.

On the bright side, though, amazing news—or at least relatively exciting for nerds like me—was released today about Facebook’s acquisition of Microsoft’s Atlas Solutions. As Reuters contributor Rebecca Grant reveals in her article, “Facebook is taking the weight-of-the-world off Microsoft’s shoulders. Today, news came out that the Facebook officially bought Microsoft’s Atlas Solutions,” the rumors that’s Facebook was planning to purchase Atlas Solutions from Microsoft were confirmed. As she relates, although the specific figure being paid for the platform is not clearly known, the deal has been officially closed. With the acquisition of the Atlas Platform, Facebook will now have access to advanced digital tracking capabilities. This will allow Facebook to provide its advertising clients with more effective tools to track and design their ad programs on the site. Until now, as Rebecca reveals, Facebook has relied on third party tracking of their advertising effectiveness and marketing tools. This transition should provide marketers and advertising agencies a better view of their ad performance and allow them to more explicitly modify their ad campaigns to achieve maximum exposure.

Also, by their elimination of third-party intermediaries in their advertising tracking and delivery platform, Facebook will be able to better take advantage of advertising campaigns within their own network data. This cost reduction looks to open up Facebook to about $2.7 billion dollars of advertising revenue for the next fiscal year. This acquisition also places Facebook in a better position to compete with Google’s advertising business and capture some of their digital advertising market share.

The effects for advertisers and investors seem pretty clear in relation to this news. If accurate, and Facebook is able to capitalize upon this program in order to streamline and better its advertising structure while at the same time stealing market share from Google; this places Facebook in an excellent position to boost their earning potential as they continue to develop this and other platforms. Advertisers and marketers should not overlook this recent development, either. With the ability to provide in house data tracking tools and ad platform services, Facebook should likely be able to reduce some of the advertising service costs for its customers—at least in theory. If this efficiency does trickle down to the individual marketing programs, we could certainly see a fulfillment of the law of demand—a decrease in price of the good causes the quantity demanded to expand.

Another key revelation of this purchase is that it proves that Facebook is working to continually evolve and adapt in the changing digital advertising market. This is certainly something that investors should appreciate in this fairly young company. I believe that the major downfall which faces Facebook is the growing popularity of its current competitor, Twitter. Although this purchase does not completely undermine this rival, it does bolster my confidence that Facebook isn’t becoming complacent about their business model and allowing market share to be lost to its major competitors.

Grasping the Graph: The Graph Search Revolution

According to this Wall Street Journal video, guest Rolfe Winkler weighs in on Facebook graph search and its potential for better advertising utilizing the social graph and Facebook network. Graph Search, only recently rolled out by Facebook, does hold the potential to undermine and capture much of the online search and advertising business currently controlled by companies such as Google and Yelp. As the video relates, although Graph Search is a new feature and will require more time and consumer interaction with businesses and corporations on the platform to build up the quality of its advertising potential, it does seem plausible to assume that this new platform has the ability to increase earnings revenue for Facebook as well as provide better solutions for its advertising clients. Graph Search certainly is an exciting new feature which Facebook is exploring, and, if managed correctly, could be leveraged to achieve substantial reward.

The Fundamental Metric

Taking a quick glance at the key statistics and financial position of Facebook’s 2012 earnings and balance sheet provides some interesting insights for investors to consider. At first glance, the firm certainly does appear to have several growth characteristics, which, as a value oriented investor I tend to stray away from. Ignoring their obnoxiously large P/E ratio (1,818.00 trailing), Facebook boasts a substantial price to book ratio of 5.45.

Aside from these valuation metrics, Facebook, whose market capitalization is now a whopping $64.96 billion, has recently experienced a revenue increase of over 40% (yoy) for the 2012 fiscal year, largely due to their recent focus on mobile advertising solutions for their advertising clients. Despite their large valuation, Facebook’s assets do exceed total liabilities by over 4 times; certainly displaying a well situated and secured financial position. Besides their total assets, they also boast a net current asset value (total current assets less total liabilities) nearly seven times greater than their long term debt, certainly fulfilling my personal criterion that long term debt is no more than 1.2 times net current assets.

Facebook’s less than stellar EPS growth does leave me somewhat weary as to the growth possibilities of the firm, despite their impressive revenue boost over the last fiscal year. From the technical side, the stock is trading seemingly in between its 52-week high and low values—$45.00 and $17.55, respectively. Shares of Facebook, currently at $27.39, are trading about $2.30 below its 50-day moving average. I certainly would like to see the stock break through that resistance line before reconsidering any technical approach.

These quick statistics certainly do not fulfill many of my personal investment criteria. In my opinion, the most disheartening of these is the lack of dividend payment (common in a newly expanding growth corporation) as well as the less than impressive earning per share growth. One important revelation of these statistics, though, is the financial stability which Facebook appears to be graced with, as evidenced by their assets/liabilities ratio as well as their long term debt structure. This strong financial position leads me to consider the overall stability which Facebook should be able to capitalize on while determining how to maximize shareholder value through its advertising business.

A Neuroscientist and an Advertiser Walk into a Bar.

The overarching question on every advertiser and investor’s mind is “do Facebook ads really work.” This question, I contend, is much less superficial than the original answers would lead ond to believe. In approaching this question, a more quantitative viz. scientific approach likely should be more favorable in actually determining whether Facebook’s ad platform serves any real use. In her sproutsocial.com article, “Study Reveals the Effectiveness of Facebook Advertising,” Jennifer Besse reveals that these scientific approaches toward understanding the Facebook ad scheme have already been occurring.

As an example of this, the author cites the study done by NeuroFocus, who utilizes an application of neuroscience to advertising brands and marketing structures in order to understand their relative efficiencies with consumer conversion. In this study, NeuroFocus compared three different online viewing experiences. Utilizing the home pages of the New York Times and Yahoo! as well as one’s personal news feed on Facebook, the study demonstrated that, with the inclusion of ads on all three platforms, those ads viewed on one’s Facebook news feed commanded much greater attention and engagement than the other web sources. Their study also revealed that people are more likely to later recall the advertisements displayed on Facebook over the other web providers. As the final culmination of their research, as Ms. Beese reports, NeuroFocus determined that Facebook ads have much better conversion and saturation rates compared to television advertisements.

Although the research is certainly interesting, after reading the article I cannot help but be imbibed with a strong sense of skepticism. Despite my personal aversion and disinterest in the fields of psychological “research,” the lack of evidence of the scientific process used by NeuroFocus leads me to question both the credibility of their research and the relevance of Ms. Beese’s article. Despite my personal prejudices against this article, though, I do believe that it reveals a very important piece of information to would-be investors and advertisers. If accurate, the fact that ads on Facebook are truly more effective than those found on television would be earth shattering. Think about the exorbitant amounts of money allocated in company budgets for television advertisements. The simple realization of the inefficiency of these ads, which have dominated the several billion dollar market for years, could cause a massive capital inflow into alternative advertising sources such as Facebook. Though I believe one should conduct further research into the overall validity of Ms. Beese and NeuroFocus’ claims, if found to hold true, this could monumentally impact Facebook’s advertising business and the creation of value for both advertisers and investors.

Doubt and Pragmatism

As an individual investor, I tend to prefer to analyze the fundamentals of a company and industry, particularly searching for undervalued organizations which can provide me a measure of safety and significant return on my investment. I could be described, although unwillingly, as one of Graham and Dodd’s groupies and have been occasionally known to sleep with my copies of both Security Analysis and the Intelligent Investor close by. That being said, I also do not completely disregard technical analysis as a heretical sacrilege to be avoided like the plague. In fact, I have even lightly dabbled in technical analysis and allowed these procedures to help formulate my own investing strategies, usually to great personal loss.

In my personal investing decisions, I prefer to invest in companies whose businesses I can easily understand, not just from a technical/fundamental perspective, but also from my individual opinion on the long term necessity of the business and the prevalence of major competitors. Though determining the futures of entire industries is more of a guessing game than an exact statistical science, I believe that common sense can be applied to understanding the future possibility of where a firm’s business is going—although it likely will be the result of random events and statistical unpredictability.

In examining the prevalence of Facebook on today’s social culture, it does certainly seem to show that Facebook has an addictive effect which entices users to keep coming back and using their product—enabling advertisers to capitalize on this addiction. Although Facebook does appear addictive to it users, I do not venture to say that it enjoys the perfect inelasticity that heroin and cocaine suppliers regularly enjoy. My chief worry in an investment in Facebook, aside from the ever changing technical and advertising landscape is the sobering process which its users might electively face in the presence of a new, more attractive social media platform. In this regard, Twitter terrifies me, as it should the owners of Facebook.

So if personal allocation of capital is the end-all-be-all of one’s trust in a corporation and its stock, one could say that I do not wholly trust Facebook’s ability to provide me a considerable margin of safety and an “assured” return on my investment. This is due primarily to the qualitative data which I have observed of Facebook, and much less on its past earnings or future earnings potential. Although I believe and hope that Facebook will be able to continue to post positive returns in the near future, the past results of services such as Friendster and MySpace leave me dubious of the long run prospects for the company. As time has proven, nothing lasts forever, especially on Wall Street.

Facebook and Charles Ponzi: Implicating Disaster

An accusation of a business undertaking having the same merit and investment worth as a Ponzi Scheme is no small statement. These scams, recently made famous by the Bernie Madoff case, involve the creation of returns and value to investors and shareholders where no real value exists. This system, which utilizes increasing investor monetary inflows to pay off earlier investors , allows the system to expand and provide highly attractive returns on investment for many investors. These returns, though, are not due to the investment merit of the fund manager or special market circumstances. They are solely created by the circular use of money provided by an expanding investor and user base. This process usually provides exceptional returns at the beginning of the fund, but as its user base and size begin to drastically increase, it becomes impossible for the fund to pay returns to old investors, and its ability to recruit new users and funds evaporates.

In his January 18, 2011 blog post, well before the company’s initial public offering, Jason Perla makes this very accusation of Facebook and its advertising business model. If true, as stated above, this would hold massive implications for the social media and advertising giant and the eventual downfall of the company as a whole. This post is exponentially more important now, than it was at the time of its original inscription. Due to the now publicly traded status of the corporation, Facebook’s ownership is now equitably distributed among millions of individual shareholders, who personal wealth and financial independence are largely impacted by the success or failure of Facebook’s business model and financial stability.

Mr. Perla, in his not so subtly titled “Facebook is a Ponzi Scheme,” lays out several principle claims about Facebook’s advertising business model, revenue streams and the eventual future of the business itself. His prominent point, as reflected by the title of the post, is that Facebook is, in reality, a Ponzi scheme. In the true sense and fashion of the term, he describes that Facebook’s business model and generation of advertising clients is primarily due to the snowball effect of new advertising users which base their election of use of the platform upon the mere presence of other companies using the advertising platform. This service growth also stems from the weighty increase of new Facebook users for personal and social use. Companies, recognizing this user flood, follow in suit by advertising their business on Facebook, hoping to eventually reach the millions of new Facebook users.

As a result of the snowball effect of users and advertising clients, Facebook has been able to generate impressive revenues and financial growth. But, as Mr. Perla cynically depicts, these revenues are essentially worthless in intrinsic value. Their worthless nature is derived from the true uselessness of Facebook’s advertising platform. In fact, as Perla states, most companies who choose to advertise on Facebook ultimately realize a negative return on their investment, and will ultimately abandon their advertising efforts on the social media platform. This negative ROI is largely due to a misunderstanding of how people use Facebook. Unlike Google, whose users are specifically searching for a product, service, or particular topic, which provides specific advertising capabilities for the company, users of Facebook do not log in searching for a particular topic. They log in hoping to interact and socialize with their friends and social circles. The presence of advertisements on Facebook is either blocked or ignored by users as an annoying burden, interfering with their primary use of the platform.

Mr. Perla’s final claim largely stems from one of Sir Isaac Newton’s famous assertions: “What goes up, must come down.” As evidenced by the glorious rise and desperate fall of services such as Friendster and MySpace, no social network is guaranteed to be dominant forever. These companies, once giant in their own right, both suffered similar falls and their ultimate destruction. Despite its growing size and popularity, Facebook is not exempt from the fate which MySpace and Friendster experienced. No doubt, another company may come around, steal Facebook’s users and popularity factor, and completely undermined the current social networking giant’s business (ever heard of Twitter?).

While he makes several valid points, within these colossal claims, a major assumption that Mr. Perla is making is that the majority of businesses using the Facebook ad platform eventually realize that their returns on investment are often negative and the Facebook advertising platform is essentially worthless for their enterprise. While he acknowledges this might not be true for small, niche businesses, he does assume this to be a universal truth for most companies.

In my opinion, based upon recent advances in Facebook’s advertising structure through projects such as graph search and Facebook mobile advertising, as well as the tangible evidence of increased conversion rates for companies advertising on Facebook, I believe that the assumption underlying Mr. Perla’s argument does not hold weight in many circumstances. Though I agree that Facebook does face severe competition and must continually adapt its business in order to stay competitive in the market, I believe that Facebook does not provide a worthless service to clients and has realized real returns on investment for many of its clients and investors.